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European equities: too much, too soon?

European equities have performed strongly in the last few months, despite a backdrop of omnipresent political risk. Ed Kevis explores whether the rally is sustainable.

Source: PT-Lens / Shutterstock.com

For much of the past decade, it has been hard to separate politics from economics in the euro area. And with much at stake in a series of elections taking place across the continent in 2017, it may seem perplexing that European equities have outperformed the US and Japan in 2017.1

The positive sentiment is reflected by the strong flows into European assets, as growing optimism over the prospects for global growth and stronger inflation spur allocations to the region. The week to April 12 saw the strongest inflows into continental shares since January 2016, according to EPFR Global.2 However, with ‘Brexit’ negotiations underway and the continent’s political map potentially being redrawn, we ask Aviva Investors fund manager Ed Kevis if more caution is called for.

After a decade of sluggish growth and uncertainty, the growth outlook for Europe finally seems to be improving. How supportive is the environment for equities?

EK: The environment looks very supportive. Economic data is fairly positive, especially in Germany. Industry surveys, such as the purchasing managers’ indices, continue to be strong; running ahead of the official data. This reflects growth and increased confidence across a number of countries and sectors. Furthermore, upgrades in European earnings’ forecasts are being seen for the first time in many years. I am upbeat on growth prospects and confidence in Europe, especially if inflation continues to pick up.

Markets seem calm despite the political risks. Why is this?

EK: The anticipated Dutch re-election of a centrist party in March helped calm market nerves. In France, while Marine Le Pen’s National Front made it to the runoff on May 7, the business-friendly candidate – Emmanuel Macron of En Marche! – looks set to win. However, whether the French election result is a relief or a shock, it is likely to have an impact on markets.

In Germany, the anti-migrant Alternative für Deutschland (AfD) party has not gained much more popularity of late and polls around ten per cent of the vote. Angela Merkel has just pulled ahead of the centre-left Social Democrats’ Martin Schulz after trailing him since February.3 The chances are that a centrist party will win in Europe’s biggest economy come the autumn.

Meanwhile in Italy, while the populist 5 Star Movement leads the opinion polls, the party looks unlikely to form a majority government in the short term. Despite calls from Italy's two largest parties – the Democratic Party (PD) and 5 Star Movement – for a snap election this year and 5 Star’s opinion poll ratings, the risk of the country leaving the euro zone, or a majority 5 Star Movement government, seems remote. Meanwhile, Italy continues to slowly but surely reform.

The market has so far been able to look through the political risks, and sentiment has been bolstered by the positive global growth outlook. However, we should not discount the possibility there will be bouts of heightened volatility in European markets through the year as elections near or political events surprise.

Why has Brexit in particular had such little impact on European markets?

EK: The UK government only invoked Article 50 in March to trigger the start of the process of exiting the EU. While there will be a lot of attention on the election and the impact of Brexit, Europe appears more important to the UK than the latter is to the former. Only around nine per cent of continental European revenues are earned by trade with the UK.

Should investors in Europe be concerned about the rise of protectionism?

EK: Potential trade wars are a concern. That said, it does not change our investment approach and high-quality businesses with strong business models should continue to perform well.

The rise in a protectionist agenda in the US has not crossed to the continent yet. We need to wait and see what policies Trump puts in place on trade. Some businesses will be more exposed to any trade wars than others. But companies should continue to do business as usual in the conditions that are known. If you have the right type of product for the US market and US buyers still need those goods, then that company can still do well.

Which sectors offer the best opportunities and, conversely, which may be overvalued?

EK: Information technology, financial services, travel and leisure and industrials seem to offer the best opportunities. By contrast, while there are some well-run businesses in the food and beverage and consumer staples sectors, valuations look rich.

After underperforming US shares since 2008, stronger flows have been seen recently into European equities. How do valuations stack up on a relative basis?

EK: US shares trade at around 18.7 times price-earnings ratio while European shares trade at 15.6 times. So the case for overweighting Europe relative to the US is strong. We are now seeing stronger upward earnings revisions in Europe relative to the US. While US earnings are likely to remain relatively strong and have outpaced Europe since the financial crisis, Europe is now catching up.

Growth in European profit margins was stronger than the US last year: do you expect this to continue?

EK: We continue to expect strong growth in European profit margins, aided by strengthening inflation. And after such strong growth in recent years, US margins may come under more downward pressure while European margins should benefit from an improving regional economy.As European earnings pick up, European companies should benefit from having higher operational leverage than their US peers.

Mergers and acquisitions activity has picked up in recent months – will this be a major driver of European equities in 2017?

EK: Increased confidence in Europe and global growth prospects among senior management will make it easier to justify acquisitions. We would expect to see more M&A across a wide range of industries, helping support the market. A more stable European currency may also encourage deals in Europe from companies outside the region. This is particularly so from US investors that have benefitted from a stronger dollar.

Some transactions are driven by a strategic rationale, such as managing the supply chain better. For instance, January’s proposed €50 billion deal between eyeware groups Essilor of France and Luxottica of Italy combines two businesses in slightly different parts of the supply chain with a view to saving costs. Similarly, there are rumours that Siemens will merge its rail business with Bombardier of Canada. That said, most European deals are likely to be among smaller companies.

Do you have any concerns over the potential impact of the European Central Bank tapering its asset purchases?

EK: Tapering should aid the outlook for equities, especially among banks. While closing the European Central Bank’s longer-term financing operations will reduce opportunities for bank funding, higher rates and lending growth should be positive for bank profits. Providing companies retain access to capital so they can invest and reward shareholders, I don’t have any concerns about the potential effect of tapering.

Are there any other factors that you expect to drive European equities over the coming months?

EK: Inflation is one thing to watch, making sure higher prices filter through to the economy as anticipated. Any sign that inflation is likely to weaken and undermine the recovery will hit sentiment. Clearly geopolitical risks could affect European assets, but they will also hit valuations elsewhere.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at April 24, 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA17/0567/31072017

Edward Kevis

Fund Manager, European Equities

Main responsibilities

Ed is the fund manager of Aviva Investors’ European Equity Income funds. His responsibilities include supporting the day to day running of all other European Equity funds run out of London office. Ed’s specialism is in the Support Services sector.

Experience and qualifications

Ed progressed to his current role in 2015 after working as the assistant fund manager for European Equities, and was initially hired as a support services equity analyst for the European and UK Equity team.
Ed began his career with Lloyds Banking Group, initially joining the Business Specialist Scheme with various roles in corporate lending, strategy and risk management in the Wholesale Banking division, and then moving to the Business Support Unit Investments team, initially in the Portfolio team but later moving to a combined transaction and portfolio role.
Ed holds a BA (Hons) in Finance Accounting and Management from the University of Nottingham, and an Applied Diploma in Corporate Banking. He has also passed Level 1 of the IMC and is a CFA charterholder.